After the exit of Pelago to Groupon and Groupon’s filings I get asked over and over again whether I think “Groupon’s Business Model is or is not sustainable”.  Today we had the discussions in our weekly staff meeting.

Most people point me to the New York Times Deal Book article by Michael J. De La Merced, a well written and concise analysis of some key metrics of Groupon’s business. But I find it amusing that in most articles – and the New York Times is no exception – authors are confusing “revenue” or “customers” with “business model”. They often try to answer the question whether or not the growth, revenue, number of customers, etc. is sustainable. But business model is a much more abstract framework (http://en.wikipedia.org/wiki/Business_model). Most of the time that happens because people actually try to answer the question “Does Groupon’s IPO make sense at the expected price?” or “Should Groupon have declined the 6 (or 9) billion US Dollar offer by Google?” or “Will Groupon’s revenue falter?”

But to decide whether Groupon’s business model is sustainable, I think there are two questions to ask:

1. Is there any business or financial theory to support the premise Groupon is built upon?
2. Are the nine building blocks of Groupon’s business model – key activities, key resources, partner network, value proposition to end consumers and businesses, customer segmentation, channels, customer relationships, cost structures, and revenue streams – the most cost effective and most cost efficient ones to allow a decent operational margin?

1/  Business and Financial Theory

Groupon right now is a platform to simplify yield management (http://en.wikipedia.org/wiki/Yield_management).

Yield management involves strategic control of inventory to sell it to the right customer at the right time for the right price. This process can result in price discrimination, where a firm charges customers consuming otherwise identical goods or services a different price for doing so.

So another concept to understand is price discrimination (http://en.wikipedia.org/wiki/Price_discrimination).

Price discrimination or price differentiation exists when sales of identical goods or services are transacted at different prices from the same provider.

Why would you start selling the same product for different prices? What is the reason for Safeway’s “buy one for 59 cents, two for 1 dollar”, for softdrink size pricing, or for senior discounts at theaters? You can sell more, of course. But will you make more money? This depends on how you set the price in the different market segments and what your operational costs are. The two YouTube videos to watch on “Price Discrimination” are

and

if you want to read up on Groupon and how it leverages these theories of economics should go to Ahmadali Arabshahi’s blog posting on “The Essence of Groupon: Price Discrimination Degree Transformation” (http://www.ahmadalia.com/blog/2011/01/the-essence-of-groupon.html).

2/  Groupon’s Business Model Building Blocks

In effect Groupon needs to make sure that

1. The building blocks “make sense” and create a cost structure that is efficient and effective “(d’oh, like in any business).
2. The underlying assumptions of the economic theories are not violated.
3. Groupon’s operation itself does not start to violate and alter assumptions of the underlying economic theories (hello Heisenberg and feedback loop).

Unfortunately I have not found an intelligent article on how Groupon-like platforms influence market segmentations per se (point 3.), and what impact the feedback loop to consumer behavior and social interaction will have on rate fences and price discrimination. Please send any suggestions to me.

When addressing the first challenge, Groupon has to make sure that businesses make money and not lose it as well as sufficient sizable deals numbers are made so that Groupon can make its cut and pay for operations. 2. means that Groupon has to to discourage discount customers from becoming resellers, etc., like a secondary market for groupons on Craigslist or eBay,  for example. The underlying financial theories have many more assumptions to keep in check.

But let’s look at the question whether a small business understands the pricing complexity, can correctly derive a market segmentation, predict price expectations, and successfully establish “rate fences”. Groupon’s business model building blocks should support businesses in making these decisions to become a valuable business relationship. If too many businesses make bad decisions, or if the competition for attractive groupons and front-page features results in a rally for mega discounts regardless of profits, then business will falter. So if the business building blocks don’t promote “good” economic decisions, then Groupon’s business model becomes unsustainable because it is not as scalable as it likes to be – It either becomes a platform of few or a platform of rip-off. Are there any tools, relationship management, or key activities to quick-check your deal settings as a business?

Example: Ayuh Yoga in Union City

On Sunday I randomly picked a deal off Groupon’s current landing page (my landing page, that is). Ayuh Yoga offers “20 drop-in classes for $20”. The classes have to be activated by today — 6/14/2011 — and are good for 2 months. At least 400 people have bought that deal. Loopnet.com says that the building at 3909 Smith Street, Union City, CA 94587 has about 3,000 sqft, and the video on Yelp shows about 12 people per class – so maybe class sizes are almost a magnitude bigger, I don’t think I need 220 sqft per person for yoga ;)  Ayuh Yoga’s schedule shows between two to four beginner or medium classes per day.  Let’s do the math: At 20 drop-in sessions over the next eight weeks it’s easily possible that 400 people are showing up at least twice a week, or even three times to max out the offer – that’s at least 800 units. Evenly distributed over 7 days (as if!) we’re at 114 people per day.

RESULT: At about 12 people per class that’s about ten classes per day – not the mainly three to six classes per day on their schedule, and surely not two to four beginner or medium classes per day on their schedule.

This is all information publicly available within seconds, I’ve actually never been to Ayuh Yoga. And that in effect means that a simple calculator could test basic mechanics when even much more accurate input from the business owners is available.

There are several conclusions possible:

• No one comes back to Ayuh Yoga (I don’t think so when you trust the reviews at Yelp – people seem pretty happy).
• Ayuh Yoga expects you to come about 5 to 8 times, not 20 times – so not even every week.
• You will encounter long lines and turn-aways – is that a positive or negative marketing effect for people with discounts and for people who didn’t take advantage of the discount? Does the scarcity create hype and craving and demand, or do you feel screwed for the deal?
• Class sizes are not around 12 people as shown in the video, but more like 30 to 40, maybe even 50 if the distribution of people is not even across the week.
• Someone didn’t do the math or didn’t care.

Note that I didn’t even touch on profitability after 50% cut of Groupon, or the operational impact, just the pure physical feasibility of the deal. For the financial side of things, an analytics engine of Groupon users would be interesting, to match for example spending of the Groupon class of customers in a restaurant against spending of usual customers. Test balloons could be started before doing more aggressive deals on larger scale.

Conclusion

Of course this is a simplified view, and one sample does not make a good sample group. But it exemplifies my believe that

1. High valued businesses do not need to dilute their brand and valued customers with discount hunters.
2. Low valued businesses will end up with a miniscule number of recurring customers.
3. The average business will so far not be able to make an informed enough decision on pricing, segmentation, and fencing, and thus is very likely to either loose money or not get the desired results.
4. As the targeting is not yet granular enough, discount offers of the average business will get drowned out in the noise of Groupon-like sites, social media lists, recommendations, facebook groups, etc. very much the average newspaper advertisement get drowned out.

BUT: there we have it! Great business ideas that Groupon – or any other similar couponing site – might be interested in acquiring or partnering with :)